Trump Trade Will Accelerate Historic Credit Bust

 

The biggest credit boom in history

US corporate cash flow/debt collapses as CFOs leverage balance sheets

While real investment collapses

CFOs just focus on stock prices

No Wonder S&P credit downgrades explode this year

The next bust period in the credit cycle has already begun!

“There are three big “tells”

The Trump Trade will add in more problems, accelerating the historic credit bust that has already begun

Higher interest rates increase the burden of new record debt levels

Higher interest rates will reduce borrowing which will slow the economy

Higher interest rates will strength the dollar which will reduce net trade, and lower import costs which raises the real interest rate and lowers growth

Dr Lacy Hunt believes Trump’s economic impact will be minor, the declining secular trend in Treasury bond yields remains intact

Summary and conclusion

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Trump Trade Will Accelerate Historic Credit Bust

The violent rush to economic judgement after the Trump election win is highly questionable. On further examination it could even be reversed before long. Just the recent market moves themselves constitute a tightening in policy at what could be a very bad time. It could even precipitate an acceleration in the bust phase of the biggest credit cycle in history.

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The biggest credit boom in history

 “Between 2005 and 2015, U.S. corporations exploited artificially low interest rates to borrow unprecedented amounts of money… 

Before the mid-2000s, U.S. corporations had never borrowed more than $1 trillion in a year. They did so twice, in 2006 and 2007 – the “boom” years. Maybe you’ll remember what happened next – a huge bust, the worst recession since the Great Depression. 

So what did Obama do to heal our economy from these wounds? He engineered an even bigger debt bubble… 

First, he doubled the amount of outstanding, freely trading U.S. Treasury debt (from $7 trillion to $14 trillion). He directly borrowed more money than all the other U.S. presidents ever borrowed before, combined. Worse, his economic team led the Federal Reserve to hold down interest rates to essentially zero. 

What happened next will scar our economy for a decade, at least. Every year between 2010 and 2015, U.S. corporations borrowed more than $1 trillion. In 2014 and 2015, they borrowed nearly $1.5 trillion. 

Junk bonds had almost never made up more than 20% of corporate-bond issuance. But during the six-year “Obama debt boom” of 2010-2015, high-yield bonds made up more than 20% of issuance in every year except the last (2015).

junkpcnt

But it’s not just that record amounts of debt have been underwritten. It’s the quality of that debt that’s the real problem. 

You see, most big banks and insurance companies aren’t allowed to buy “junk” bonds. Therefore, most investors don’t worry too much about the junk-bond default rate. 

But… what if investment-grade debt has suffered the same kind of quality impairment? 

Over the past decade, the lowest-quality tranche of investment-grade debt, debt rated “BBB,” has grown from around 10% of total investment-grade issuance to more than 30%. 

While I don’t think BBB debt will default at anything like junk-bond rates, I’m certain that during the next credit-default cycle, the annual default rate on the lowest rung of investment-grade debt will be at least triple its former peak (1% in 2002). 

If we see three or four years of default rates at this level (say 3%), you’re going to see big losses at major financial institutions. These losses will be more than enough to cause the collapse of at least one or two big firms. (We’re talking about $200 billion-$500 billion in investment-grade-bond defaults.) This will send a wave of panic through the markets. Combined with junk-bond losses, all this will dwarf the losses caused by bad mortgages.

This big change in the underlying soundness of the corporate-bond market guarantees that during the next credit-default cycle, losses are going to be far bigger and hit far more companies and investors than ever before… and much more severely.”

Porter Stansberry

US corporate cash flow/debt collapses as CFOs leverage balance sheets

Usually, as we can see from the chart below, there is a natural limit to corporate debt. Corporate CFOs normally cut back on debt issuance as cash flows decline as a proportion of debt, and the gearing, or leverage, becomes problematic.

This was a very good leading indicator for the stock market in both the 2000 and 2007 stock market bubbles. However, this time around, despite the record amount of debt issuance, it has not happened. Cash flows/debt has been falling for 5 years, but the stock market has continued its relentless rise!

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While real investment collapses

It seems clear that corporate managers have used lower interest rates as more of an opportunity to leverage their balance sheets, with more debt, and buy back their own shares, rather than directly invest in businesses. The chart below shows the long term collapse in US Domestic Investment, despite the explosion in corporate debt. This explains, at least in part, the extraordinary rise in the US stock market. It boosts earnings per share and boosts stock prices. Both are to the short term benefit of corporate managers.

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http://www.hussmanfunds.com/wmc/wmc161114.htm

CFOs just focus on stock prices

Sooner or later all this much debt, much of it highly unproductive, is going to be a problem. Lately corporate managers have even been accelerating debt when there cash flow has stopped growing!

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No Wonder S&P credit downgrades explode this year

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The next bust period in the credit cycle has already begun!

Stansberry writes:

“There are three big “tells”

First, total U.S. corporate debt is now 45% of GDP. That’s where the two previous credit cycles peaked (’02 and ’08). It’s simply not possible that the amount of credit outstanding to corporations can grow much from here because, even at very low rates of interest, there are not enough willing borrowers. Think about yourself. Does it really matter if someone offers you a 2% rate on a credit card? Are you going to go into debt for any reason? Nope.pic6

Second, and far more important when it comes to timing, the number of banks in the U.S. that are tightening lending standards is rising and has just passed a critical threshold (10%). Banks tend to tighten lending standards at the same time, at the end of a credit cycle and beginning of a default cycle.pic7
Third, we know for sure that a new default cycle has begun because not only are banks tightening, but credit downgrades (by the ratings agencies) have bottomed (in 2014) and continue to grow substantially. Likewise, outright default rates have bottomed and continue to grow rapidly. Morgan Stanley’s top high-yield bond analyst (Meghan Robson) believes the default rate in high yield will hit 14% by the end of 2017 (it was basically zero in 2014). She also says the total default rate will peak at 25% annually within five years.”

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The Trump Trade will add in more problems, accelerating the historic credit bust that has already begun

Higher interest rates increase the burden of new record debt levels

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But this has happened while interest rates have fallen.

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So most investors don’t understand the enormous interest rate burden of higher bond yields. The last time bond yields were significantly higher the debt was nowhere close to where it is today. A rise in yields of just 1% increases the interest cost of just government debt by around $200 Billion!

http://danielamerman.com/va/Conflict.html

The bigger Trump’s deficit spending is the higher interest rates will be and so also the extra interest cost of the deficit!

Higher interest rates will reduce borrowing which will slow the economy  

It’s already happening just in housing. The chart below shows the immediate response in terms of lower mortgage applications.

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http://www.zerohedge.com/news/2016-11-16/mortgage-applications-crash-30-borrowing-rates-surge

Higher interest rates will strength the dollar which will reduce net trade, and lower import costs which raises the real interest rate and lowers growth

pic12

 

http://www.zerohedge.com/news/2016-11-15/import-prices-decline-record-27th-month-china-exports-most-deflation-6-years

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http://www.zerohedge.com/news/2016-11-07/china-trade-data-disappoints-again-despite-plunging-yuan

 

Dr Lacy Hunt believes Trump’s economic impact will be minor, the declining secular trend in Treasury bond yields remains intact

“The most potentially dynamic component of the Trump plan is the reduction in tax rates. The plan calls for a $500 billion decrease in taxes over the next ten years. With a tax multiplier of –2, there would be a lift in economic growth of $1 trillion over the next ten years for an economy that is on a growth path of about $5 trillion over that same time frame. As such the annual growth could be boosted from $500 billion a year to $600 billion. This stimulus will take a considerable amount of time to work through the economy and the positive contribution requires that monetary conditions remain favorable, not adversarial.”

As we discussed above they see that markets have already tightened to offset the growth additives we don’t even have yet. Then they conclude:

“Markets have a pronounced tendency to rush to judgment when policy changes occur. When the Obama stimulus of 2009 was announced, the presumption was that it would lead to an inflationary boom. Similarly, the unveiling of QE1 raised expectations of a runaway inflation. Yet, neither happened. The economics are not different now. Under present conditions, it is our judgment that the declining secular trend in Treasury bond yields remains intact.”

 

http://ggc-mauldin-images.s3.amazonaws.com/uploads/pdf/OTB_Nov_16_2016.pdf

 

Summary and conclusion

Markets have rushed to conclusions following the Trump election, which has produced extremely rare market behavior. Often with poor outcomes.

1116only-12-days-since1970near-highs

 

This has been a rush to judgment on policy that has not yet even been determined and even when it is, will be months to implementation in the future. Yet we can see that this futurism is actually already having immediate NEGATIVE impacts.

Furthermore, it comes at a very bad time for the extreme conditions in the already developing biggest credit bust in history.

Investors need to tread very carefully in these very untested and challenging conditions.

If the Trump Trade just accelerates or even sets off the Big Trade, then how much stimulus will Trump have to provide? Will the interest cost from the deficit financing even be bearable at higher yields?

Investors should wait for much more evidence before jumping onto the Trump Trade. It may well be a better strategy to plan on fading the Trump Trade as its momentum fades with Stansberry’s Big Trade which targets the historic credit bust that has begun.

Here is the Goldman Financial Conditions index (inverted) showing some tightening in the US. It shows that index compared with the S&P 500 in the chart below.

Something’s got to give.

1116goldman

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